It’s the start of a new year; the traditional time for self-examination, reflection, and a new list of resolutions intended to help us work on those aspects of our lives we feel could use some improvement. Some common areas for New Year’s Resolutions include:
 

  • Starting a healthy diet and exercising more to improve our health,
  • Becoming more organized to make better use of our time,
  • Reading more or taking a class to promote our personal or professional development, and
  • Reviewing our financial plan to make sure we’re still on the path to achieving our important life goals.

 
For many people, the keys to successfully keeping their resolutions is making them specific and writing them down. A mental note to eat right and exercise more probably won’t be as effective as a written goal that can be reviewed and measured, such as “eliminate all snacks after 9:00 PM”, or “exercise for 30 minutes every day.”
 
It’s been our experience that long-term financial goals are also more likely to be achieved when they are specific and in writing. This is one of the reasons we recommend every individual investor have what institutional investors such as pension plans have – a written Investment Policy Statement (IPS).  This goes for advisors as well.
 
The beginning of a new year is as good a time as any to take a fresh look at your clients Investment Policy Statement. Have there been significant changes in the financial picture: a job change, more or less regular income, an inheritance, new expenses, or new or revised goals? This review is about the client, and changes in circumstances – not about the markets. The investment environment is always changing, and a well thought out plan should already take changing markets into account. Be careful not to let what’s going on right now in the investment markets alter you or your client strategy. Neither Bull nor Bear markets last forever, and we’ve seen too many advisors and investors change their plans based on their recent experience just in time to be out of step with what’s coming next.
 
The purpose of the IPS is to put in writing exactly what someone is trying to accomplish with a portfolio, how to plan to get the job done, and how to measure progress along the way. It should serve as the anchor that keeps from drifting away from a plan to chase the latest hot tip or investment fad. By helping clients to stay focused on long-term goals, it can also keep them from becoming discouraged by the inevitable setbacks that they give up on investing altogether. An IPS doesn’t have to be a complex document, but it should include the following:
 

  • Risk tolerance
  • Time horizon
  • Need for current income
  • Need for long-term growth
  • Plan of action
  • Schedule for measuring progress

 
A great way to measure risk tolerance is for an advisor to ask a client how much they are prepared to lose without abandoning your strategy. Use the real dollar value of accounts as the starting point. It’s one thing for a client to sit calmly through a decline of some theoretical percentage; it’s quite another to open an account statement and see that loss translated into a big chunk of money that’s now gone. A not so great way to measure risk tolerance is to change  “acceptable risk” to whatever it would have to be to justify switching to investments with the highest recent returns.
 
One way to keep portfolios on target is by using client annual reviews to have a complete view of all various client accounts – back into balance. Rebalancing money from strategies that have done well into those that may be undervalued. This process helps bring all client accounts back into alignment with risk tolerance and long-term goals. If you accept that one of the keys to successful long term investing is to “buy low and sell high”, rebalancing is an effective strategy to do exactly that – selling high some of the quality investments that have gone up, and buying low some of the quality investments that haven’t yet.
 
Chasing returns, on the other hand, may help explain why investors so often seem to do the exact opposite: buy high and sell low. A recent report from the Investment Company Institute (ICI) on mutual fund investment flows suggests some of this could be happening right now.
 
In 19 of the 20 months spanning May 2011 through December 2012, investors pulled money out of equity mutual funds totaling more than $320 billion dollars. In 19 of those same 20 months, investors poured more than $393 billion into bond mutual funds. So what followed in 2013?  As we have seen, most major stock indices recorded solid gains, while bond indices took losses.

Now that the S&P 500 is back in the news for its recent performance, and bond prices have been falling, investors appear to be shifting gears. The ICI data show net inflows for equity funds in every month of 2013 amounting to almost $169 billion. Meanwhile, inflows into bond funds steadily dwindled during the first five months of 2013, and have turned to outflows of $176 billion in the seven months since.
 
Bonds provide current income and can be a counterbalance to other investments in a portfolio, yet how many investors for whom some allocation to bonds would be appropriate are turning away from them now because of their recent slide?  It’s possible, of course, that the massive flows out of bond funds simply reflect some coincidentally synchronized change in the personal financial circumstances of a huge number of investors. Maybe lots of people got a big raise, or inheritances, or don’t need as much income from their investments now as they did at this time last year. More likely, we think, is that investors have changed their “risk tolerance” in the face of the stock market’s well publicized gains. The 57% plunge in the S&P 500 a few years ago may have faded a bit from memory, and the role bonds can play in offsetting stock market volatility in a balanced portfolio may seem less important now that stock indices are hitting new highs. A stock market correction that brings with it a flight to quality may leave today’s sellers wishing they had held on to their bonds a bit longer – or even added to their lagging fixed income holdings.
 
Just because the S&P 500 enjoyed solid gains in 2013 and has more than doubled since its low in March 2009, doesn’t mean it can’t keep right on rolling higher in 2014. Still, signs of overly optimistic investor sentiment are increasing just as good values in the stock market seem to be getting harder to find. Markets can and do correct, sometimes suddenly, and investors who drift too far from their plan may get a painful reminder of what their risk profile really is.
 
Our goal for 2014 is to provide our clients with the investment experience they need to keep their plans on track. As we start the New Year, we resolve to follow our disciplined investment process with every managed portfolio – and that’s a resolution we’ve carved in stone.